Mar 25, 2015

What Is the Future of Marketplace Lending?

By Kellogg Insight | Based on the insights of Paul Christensen

In 2007, Lending Club was just another technology startup seeking venture capital. Today it is at the forefront of a growing financial trend, referred to interchangeably as “peer-to-peer” or “marketplace” lending. Last December, the company raised almost $900 million in one of the largest IPOs of 2014, suggesting that online consumer lending might disrupt the market for traditional bank loans. But Lending Club’s first earnings report failed to meet expectations, leading to questions about whether marketplace lending is overhyped.

Dubbed “eBay for money,” Lending Club is an online platform designed to bring people in need of loans—$1,000 is the preset minimum, $35,000 the maximum—together with investors seeking better returns than they would get at a bank. Borrowers’ interest rates are determined based on credit scores, and lenders have the flexibility to invest as little as $25. By cutting out the administrative costs associated with bank loans and streamlining the process, the company has become the world’s largest peer-to-peer lender.

Marketplace lending grew out of frustration with the banking system in the wake of the global financial crisis. “It is not a coincidence that we saw the rise of these new peer-to-peer models around the same time as the crisis,” says Paul Christensen, a clinical professor of finance at the Kellogg School and an expert on microfinance. Banks tightened credit, leaving people to seek out alternatives. Lending Group and its peers were able to tap into that latent demand.

“This is not a fad,” Christensen says. Just as Uber and Airbnb have disrupted traditional hotel and taxi services, Lending Club is offering people alternative ways to borrow and lend. “The question,” he says, “is whether it will evolve beyond niche credit markets.”

Christensen remembers a similar buzz surrounding microfinance. “For many years the only way to invest in microfinance was to have big bucks,” Christensen says. “Then Kiva”—a social enterprise that allows individuals to make small loans—“came along and made it something anyone could do.” Kiva is a nonprofit—not a licensed broker—but it was one of the first to prove there was a viable market for individual lenders and borrowers. “There is a parallel between microfinance and marketplace lenders in the sense that they are filling a gap,” he says.

Lending Club in particular has made a splash in the market. In February, it struck a deal with a consortium of 200 community banks that will use the company’s credit-score software to vet potential borrowers and therefore offer more loans. Lending Club’s new partnerships are indicative of a noteworthy shift. The company is no longer just a matchmaker for individuals; now more than half its loans are funded by hedge funds and other major investors.

One potential limiting factor is whether marketplace lenders are able to properly manage risk; skeptics argue that only banks are truly capable. “We love to hate them,” Christensen says, “but one thing banks are relatively good at is assessing and managing credit risk. We’d be foolish to forget that the housing mortgage crisis was caused, in part, by non-bank mortgage lenders like Countrywide Financial. Most people still feel comfortable with banks. We need reasonable credit systems in place to make sure depositors don’t get burned.”This raises the prospect of increased government regulation, especially if the authorities sense a greater systemic threat. Lending Club is regulated by the Securities and Exchange Commission, which means it must comply with federal and state consumer lending laws. Still, the company’s legal framework is relatively new.“It all looks good on paper,” Christensen says, “but governments care about the safety and stability of the financial sector, so if it destabilizes credit markets, I guarantee the government will step in.”

Christensen sees a role for marketplace lending in the future of finance—but he thinks it will be a limited one. “My impression is that these guys will succeed, but mostly in niche markets,” he says. Student loans, consumer debt refinancing, and small business credit, for example, offer huge opportunities for marketplace lenders. Still, he says, it will not become a primary source of capital for the economy at large. Despite Lending Club’s recent success and potential for further growth, it is not a broadly diversified lender with the capacity of a large bank. “My sense is that it will be a long time before this poses a threat to traditional finance.”